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Large Banks and Small Banks in an Era of Systemic Risk Regulation

The financial crisis and its aftermath
have revealed fundamental problems in both risk management by
financial institutions and supervision by government regulators.
These shortcomings arose in no small part from a failure by both
the private and public sectors to adjust to far-reaching changes in
financial markets over recent decades. There is a growing, though
certainly not unanimous, view that supervision and regulation must
be substantially more oriented toward containing systemic risk and
addressing the associated problems posed by institutions considered
too-big-to-fail. The public policy agenda will thus rightly be
dominated for some time by proposals for legislative and
administrative measures directed at systemic risk. In a moment I
will offer some of my own views on the subject.

Even as we move into this era of systemic
risk regulation, however, it is important to recognize that changes
in the financial services industry have affected every bank in
America, large and small. While smaller banks will not likely see
the extensive supervisory changes that have been proposed for the
largest financial institutions, they too must adapt their
risk-management practices to new competitive and economic
conditions. Only by doing so will they continue to play their
distinctive role in providing credit to individuals and small
businesses.

The changes in the financial services
industry that preceded the crisis, the crisis itself, and the
regulatory changes that will follow together carry important
consequences for all banks. It seemed to me particularly
appropriate to address the implications of these changes here in
North Carolina, home to institutions that range from the very large
to the very small.1

Large Banks

If we have learned anything from the
present crisis, it is that systemic risk was very much built into
our financial system. This situation was the outcome of a
decades-long trend, during which traditional bank lending, trading,
and other capital markets activities were increasingly integrated.
The most visible manifestations of this trend were the explosive
growth of securitization and the increasing involvement of banks
and their affiliates in all parts of the securitization process.
And, as we learned during the course of the crisis, the universe of
institutions whose potential failure was regarded as having
systemic consequences extended well beyond banks, or even bank
holding companies, to include financial firms not subject to
mandatory prudential regulation.

More generally, the emergence of the
so-called shadow banking system changed important features of the
traditional banking model, particularly at the largest
institutions. These banks became increasingly dependent on the
wholesale funding provided by securitization, commercial paper
issuance, and other sources–funding that was often poorly matched
to the maturity of the firm’s assets.

The result was the rising vulnerability of
these institutions to non-traditional sources of risk. The new
market-based liquidity problems arose from sudden, sharp movements
in asset prices that led to enormous market uncertainty concerning
the values of those assets. As now liquidity-strained institutions
made increasingly distressed asset sales, they placed further
downward pressure on asset prices, leading to margin calls for
leveraged actors and mark-to-market losses for all holders of the
assets. Since multiple firms were relying on similar marketable
assets as a ready source of liquidity, extreme price declines could
ensue, engendering a negative feedback loop that, if unchecked,
would threaten the solvency of firms operating on the assumption of
liquidity through asset sales or borrowings secured by such
assets.

These and other changes in the competitive
environment both prompted and advanced the relaxation over the past
few decades of many of the restrictions on bank activities and
affiliations that had been established in the 1930s. As a result of
these changes, which had taken place both through administrative
action and by statute, banks could operate nationally, had few
practical restrictions on their ability to pay competitive deposit
rates, could conduct a much broader range of activities within
their own operations, and could affiliate with virtually any kind
of financial firm. In response to now-permissible bank involvement
in more activities and affiliation with broker-dealers and other
financial firms, regulatory agencies imposed more detailed capital
requirements and insisted on better risk management. But there was
no overhaul of financial regulation to take account of the impact
of trading and capital market activities on both traditional
banking and systemic risk.

The financial crisis has focused the
attention of policymakers on the need for just this kind of
regulatory reorientation. I have recently set forth a fairly
extensive explanation of the changes I believe should accompany
this reorientation.2 I will not repeat this whole agenda today.
Instead, let me simply highlight a few of these items to illustrate
concretely what an era of systemic risk regulation would look
like.

First, within the Federal Reserve, we are
adjusting our consolidated supervision practices to take greater
account of the risks faced, and created, by affiliates principally
involved in trading and other capital market activities. Recent
supervisory practices had not moved quickly enough away from the
traditional focus on bank holding company regulation as a way to
protect the insured depository institution subsidiaries, and toward
more attention to such factors as the common exposures of different
affiliates within the consolidated entity.

Second, we must strengthen existing
regulations and supervisory guidance, particularly in areas in
which bank involvement in trading and markets is most significant.
The centrality of liquidity problems to the crisis requires
considerable attention to adequate liquidity risk-management
practices, particularly at firms substantially reliant on wholesale
funding. While the most serious liquidity problems occurred outside
traditional commercial bank lending and borrowing activities, the
crisis revealed significant fragilities in financial institutions’
extensive use of short-term repurchase agreements and reverse
repurchase agreements to finance large portions of dealer inventory
and trading positions. On the other side of the balance sheet,
capital requirements for assets in the trading book were revealed
by the crisis to be seriously deficient, based as they were on only
a 10-day trading horizon. Along with our colleagues in the other
regulatory agencies and, indeed, with our international colleagues
in the Basel Committee on Banking Supervision, we are working on
proposals to address these problems.

Third, we are augmenting our supervisory
approach for bank holding companies to include a more explicitly
systemic perspective. “Horizontal reviews” of risks, risk
management, and other practices that are conducted across multiple
financial firms and grounded in a uniform set of supervisory stress
parameters can help identify both common trends and firm-specific
weaknesses. We will incorporate into more routine supervisory
practice some lessons learned from our recently completed
Supervisory Capital Assessment Program of the nation’s 19 largest
bank holding companies.

Fourth, it is important to solve through
legislation the so-called boundary problem in financial regulation.
Last year there was a series of runs on nondepository financial
institutions that raised systemic concerns. Institutions that may
be considered too-big-to-fail, or at least
too-interconnected-to-fail, must be subject to regulatory
requirements and consolidated supervision.

Of course, these are not the only steps I
would recommend, either within the Federal Reserve or for the
financial regulatory structure more generally. They should,
however, give you an idea of the kinds of changes that will be
necessary as we shift to a focus on systemic risk regulation.

Small Banks

Let me turn now to the situation of
smaller banks–here in North Carolina and around the nation. The
financial crisis did not originate in smaller banks, but they have
hardly escaped the fallout from the crisis itself, and from the
serious recession that has followed. On average, commercial banks
with less than $1 billion in assets reported a modest net profit
during the first quarter of 2009, recovering from an average loss
position in the fourth quarter of 2008. But this average figure
hides the fact that nearly one in five of these banks lost money in
the first quarter. As of March 31, nonperforming assets were twice
the level of one year ago, and when measured against total loans
and the category of Other Real Estate Owned, stood at an historic
peak. Furthermore, capital ratios, although still strong for these
banks as a group, have fallen since early 2008.

At the same time, the importance of
traditional financial intermediation services, and hence of the
smaller banks that typically specialize in providing those
services, tends to increase during times of financial stress.
Indeed, the crisis has highlighted the important continuing role of
community banks. This seems an opportune moment both to review the
virtues of community banking and to identify some of the
difficulties faced by community bankers during this recession and
beyond.

The dramatic changes in the U.S. financial
services industry that I described earlier have also produced a new
competitive environment for community banks. Consolidation has
reduced the number of banking institutions (that is, commercial
banks and thrifts) in the United States by nearly 50 percent since
1989. The number of community banks has declined by a similar
percentage, leaving the share of all banking institutions that are
community banks virtually unchanged.3

Even as the number of banking institutions
has been declining, the number of banking offices (branches plus
headquarters) has been growing. Not surprisingly, big banks have
been the drivers of the increase in banking offices. Since 1989,
the number of community bank offices has declined by about 14
percent. The number of offices per community bank did increase from
2.4 to 3.9, but even this 60% growth must be understood in the
context of the changes in larger banks. In this same 20-year
period, the number of big bank offices increased by about 42
percent, and the number of offices per big bank more than tripled,
from just under 17 to nearly 55. The net effect was a decline of
more than 25 percent in the share of banking offices operated by
community banks. The shares of deposits, banking assets, and small
business loans held by community banks have declined substantially
as well.

These declines can be explained by a
number of factors, including legal developments, technological
advances, and changes in the business strategies of larger banks
and non-bank financial service providers. For example, deregulation
has allowed banks to expand their geographic reach, facilitating
the formation of a number of large, geographically diversified
banking organizations. These large banking organizations can now be
found in many local markets, competing for business with the
community banks that call those markets home. Here in North
Carolina, the number of large banks with a branch presence in the
state has more than doubled over the past twenty years, from 18 to
39.

At the same time, technological advances
have made information about households and small businesses more
readily available, allowing some (typically large) institutions to
substitute credit scoring for more costly traditional techniques in
the underwriting of some types of consumer and small business
loans. This development has allowed larger banks to compete more
effectively with community banks in providing these types of
loans.

Another salient change in the competitive
environment is that non-bank financial service providers have
become increasingly important participants in the financial
services sector, capturing a large and growing share of the retail
financial services business. For example, while the number of
credit unions has declined by 42 percent since 1989, credit union
deposits have more than quadrupled, and credit unions have
increased their share of national deposits from 4.7 percent to 8.5
percent. In addition, some credit unions have shifted from the
traditional membership based on a common interest to membership
that encompasses anyone who lives or works within one or more local
banking markets. In the last few years, some credit unions have
also moved beyond their traditional focus on consumer services to
provide services to small businesses, increasing the extent to
which they compete with community banks.

These changes have posed significant
challenges for community banks. Even so, many community banks have
thrived, in large part because their local presence and personal
interactions give them an advantage in meeting the financial needs
of many households, small businesses, and agricultural firms. Their
business model is based on an important economic explanation of the
role of financial intermediaries–to develop and apply expertise
that allows a lender to make better judgments about the
creditworthiness of potential borrowers than could be made by a
potential lender with less information about the borrowers.

A small, but growing, body of research
suggests that the financial services provided by large banks are
less-than-perfect substitutes for those provided by community
banks.4 Consistent with this view, one study finds that the
increase in competition from large, geographically diversified
banking organizations has not affected the profitability of
community banks in urban areas. There is some evidence of a
profitability effect in rural areas, but it is actually more likely
to be positive than negative.5 Thus, for most community bankers,
the increased presence in their local markets of large,
geographically diversified banking organizations appears not to
adversely affect profitability. This circumstance may be due to the
fact that a branch manager at a large depository institution
typically does not have the same local connections and
relationships as a community bank president.

Furthermore, although survey data indicate
that small businesses have increased their reliance on large banks
and non-bank financial service providers in recent years, the data
show that these same firms have not reduced the average number of
financial services they obtain from community banks. Rather, small
businesses are, on average, using more financial services and types
of services than they have in the past, and are obtaining these
services from a greater number and wider variety of financial
institutions, often including community banks.6

To remain successful, any business must
adapt to a changing competitive environment. The adaptation of
community banks over the past two decades is evidenced by the
substantial changes in their balance sheets, on both the asset and
liability sides. On the asset side, both the average ratio of total
loans to total assets and the average share of lending comprised by
commercial real estate loans have increased markedly. On the
liability side, reliance on deposits of individuals, partnerships,
and corporations has declined somewhat, and there has been a
dramatic increase in the share of community banks that hold
brokered deposits. In addition, community banks have become more
reliant on non-interest sources of revenue.

These changes in business strategy, which
undoubtedly helped to maintain community bank profitability over
much of the past two decades, may in the current financial
environment exacerbate the risks faced by community banks. In this
difficult operating environment, Federal Reserve examiners are
encouraging community banks to focus on maintaining sound loan
quality and strong credit administration practices. In addition,
they are working with community banks to ensure that they maintain
appropriate capital planning, credit administration, and liquidity
management policies.

For example, earlier this year, the
Federal Reserve issued supervisory guidance (SR letter 09-4) that
reemphasized the importance of capital planning and prudent
dividend policies for bank holding companies (BHCs) and their bank
subsidiaries. This guidance–which was directed at all BHCs, both
large and small–reminded them to ensure that they remain sources
of strength to their bank subsidiaries and to curtail dividends
when their financial condition is under stress.

A key part of any effective capital
planning process is an evaluation of the risk posed by
concentrations in specific portfolios of loans or other assets, and
of the buffers necessary to offset potential losses on these
holdings. In late 2006, the banking agencies issued guidance
addressing concentrations in commercial real estate lending. This
guidance set forth supervisory expectations for the management of
risks stemming from these and other concentrations, including
consideration of the effects of stressed market conditions on a
bank’s assets and capital. In the time since this guidance was
issued, examiners report that many community banks have conducted
rigorous and effective stress tests. But examiners have also
visited many institutions that have only recently begun the
essential step of ensuring that their management information
systems are sufficiently detailed to support a robust analysis of
bank concentration, and identifying where more work on stress
testing is needed.

Funds management has also been an area
that has received a renewed supervisory focus at banks of all
sizes. As depositors and other funds providers have become more
sensitive to bank risk, many banks have reinforced their
contingency funding plans and developed sophisticated systems to
more closely track their sources and uses of funds. These steps are
particularly important for banks facing weaker asset quality.

Conclusion

The differences in the business models of
systemically important financial firms and community banks are
obvious. Yet the financial crisis and ensuing recession have
revealed deficiencies in risk management in institutions of both
types. Changes in competitive environments require banks to respond
with changes in their business strategies. But the financial crisis
has also revealed the importance of banks adopting risk-management
strategies appropriate to these strategic changes, and of bank
regulatory agencies adapting their supervisory models to both these
kinds of changes in financial institutions.

The characteristics of the financial
services industry have changed enormously in the last 30 years.
Along with the nature of the regulatory regime that will be
effective, the key aim of prudential regulation remains what it has
always been–to encourage the efficient allocation of capital to
productive uses while protecting the system from the defects and
excesses that are inherent in financial markets. As we recover from
the crisis and the recession, we will likely be entering a new era
in which systemic risk regulation assumes much greater importance
for supervisors. But the role of bank management, and of risk
management at banks, will also remain what it has always been–to
allow these institutions to play an effective intermediating role
in a safe and sound fashion.